Thoughts on revenue recognition

In reading the FASB’s Discussion Paper on Revenue Recognition with Contracts with Customers, what immediately stands out is the intended breadth of the proposed model. The Discussion Paper states that the model would apply to “all contracts with customers”, with contract being very broadly defined, although still consistent with IASB and commonly used US legal definitions of the term. Such broad standardization raises the question: will this standard increase or decrease opportunities for managers to exercise discretion over revenue recognition?

While standard setters seek to increase consistency and comparability in accounting information, research shows us this often comes at the expense of relevance. One particular instance that comes to mind is the implementation of SOP91-1, the AICPA’s Statement of Position on Software Revenue Recognition, which effectively standardized the requirements for revenue recognition for software sales, limiting managerial discretion.

In a 2001 research paper, Kasznik examines the effect of SOP91-1 on the value relevance of earnings, comparing the originally reported earnings with the restated, more conservative, earnings. The results suggest that the discretionary portion of earnings (eliminated by SOP91-1) provides information content incremental to the restated earnings numbers, and that after implementing the new standard, the sample firms experienced a decline in the value relevance of reported earnings. In contrast, firms that did not have to restate (those whose revenue recognition policies were already in compliance with SOP91-1) experienced no such decline.

Due to the reduction of managers’ ability to communicate with investors through accounting discretion, the value relevance of earnings for the sample of software firms declined after SOP91-1 became effective. To compensate for this, some of the firms in Kasznik’s sample turned to more costly (and unaudited) channels of voluntary disclosure of forward looking information, particularly long horizon forecasts. Although standardization may have improved the consistency and comparability of software firms’ reported revenue numbers, it also decreased their relevance to investors while imposing additional costs, both explicit and implicit, on firms.

This is only one of many studies that have shown that discretion in accounting is an effective and valuable channel of communication from managers to investors. If standardizing revenue recognition criterion only within a single industry results in a loss of relevance, we must ask: what would be the effect of standardization across all firms? Certainly an overall theory, or framework, for revenue recognition criterion is important to accounting, not just as an academic discipline, but in practice, as well. However, standard setters must continue to strive for a balance between relevance and reliability so that financial statements remain a meaningful tool for investors.

One area of particular concern to us is the proposed accounting for long-term contracts: if you don’t actually turn over all legal rights to and control over, say, the 1/2 of that cruise ship you have just built for someone over the last 2 years, you don’t get to report any of the revenue. In this case, standardization is going to lead to one of two possibilities: either firms will alter their contracts to allow for transfers of legal rights and controls for partially-complete projects, or they will communicate outside the normal accounting venues in ways that are neither audited nor standardized.

I think this is a case where the ‘standard’ approach really is a straightjacket, and the option is a highly discretionary workaround that may not be very satisfactory for preparers or users.

It is amazing that we currently have over 100 standards that deal with revenue recognition. I share the board’s view that we need to simplify the system to make it more useful. However, there are concerns about both the relevance and comparability of revenue as a consequence of standardization.

Given the board’s objective to enhance consistency and comparability, it is not surprising that the proposed approach might lead to less managerial discretion in accounting for revenue. An immediate consequence is the concern about the relevance of revenue as raised by Jamie and Prof. Bloomfied. This leads to another problem: a dollar revenue of firms in different industries might have different economic meaning. As a result, comparing revenue across firms in different industries might be meaningless. In other words, standardization might decrease (instead of increase as intended) the comparability of revenue.

However, through reading the discussion paper, I think it is unclear whether the board’s proposed approach would increase or decrease manager’s discretion in accounting for revenue. Under the proposed approach, revenue is recognized based on the entity’s net position in a contract. The definition of net position is very broad, which might offer more discretion in determining when an entity should recognize revenue. For example, if we allow different industries to apply different criteria in determining when an entity’s net position changes, then the concern about reduction in relevance due to standardization might be addressed. Of course, allowing varying practices across industries raises the concern that we might be taking a round trip to nowhere.

The board is under pressure from many constituents with conflicting interests. In my view, the board’s job is not to find a correct solution but to err in the direction that is least costly. In this specific situation the board has to balance between comparability and relevancy. I hope that we will have an office hour to discuss the comment letters that the board received, and to reconcile those comments with academics’ views.

Jamie states: “If standardizing revenue recognition criterion only within a single industry results in a loss of relevance, we must ask: what would be the effect of standardization across all firms?”

I find it ironic that Jamie criticizes (or at least calls into question) the proposed revenue recognition model because of its potential effect on relevance. In writing the proposed new model, one of the primary concerns among standard setters was the decrease in relevance that occurred when SOP 97-2 and EITF 00-21 required a deferral of revenue because undelivered elements in an arrangement lacked objective and reliable evidence of a separate selling price. The proposed new model (much like current proposals under EITF 08-1) would undo this outcome by allowing entities to estimate the standalone selling price of elements in an arrangement in order to allocate the transaction price across all elements. As a result, the pattern of revenue recognized would more faithfully represent the pattern of goods and services transferred to the customer. This, in turn, should make recognized revenue more relevant.

On a more general note, I think standard setters would like to see similar economic transactions presented consistently and in a way that is comparable across entities and industries. However, at the same time they would like the principle underlying any standard to be flexible enough that different economic transactions get presented differently. In other words, standard setters do NOT want to see different economic transactions forced into the same accounting (which would cause the loss in relevance the original post seems to fear).

As you can imagine, the difficulty here is in identifying what “economics” you want the accounting to capture. For revenue recognition, do you want to capture when cash is received (i.e., a cash based model), when a promise of cash is received (i.e., a collectible receivable model), when an entity has satisfied a promise in a contract (i.e., a performance obligation satisfaction model), or some combination of these events? The existing definition of revenue is so broad that it allows for any and all of these events to give rise to revenue. For example, it allows for the creation of an asset (such as growing timber or constructing a building) to give rise to revenue. It also allows for the reception of cash or a receivable in exchange for a good or service to give rise to revenue (such as with retail sales). The fact that so many different transactions or events meet the existing definition of revenue helps explain why there are more than 100 standards on revenue recognition in US GAAP.

I think the goal with the proposed revenue recognition model is to narrow the events (i.e., changes in assets or liabilities) that lead to recognition of revenue. By focusing only on changes in contracts with customers, the standard setters have created some difficulties for situations such as construction contracts or the growing of timber and other biological assets. In order for revenue to be recognized in these situations, standard setters have to think hard about how a contract with a customer changes for constructed assets and biological assets, and this has been a thorny issue. To the extent that relevant information on the activities of construction companies and biological/agricultural entities decreases because of the proposed model, I think Jamie’s and Rob’s posts are particularly on point.

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